Trading Amazon Before Earnings

Jul.24.12 | About: Amazon.com, Inc. (AMZN)

In option trading the long straddle, similar to a long strangle, is a strategy based on buying a stock option with the same strike price and expiration of both a call and put. Why would an investor want to buy the same strike price and expiration of both a call and put? The goal of a long straddle is to profit if a stock moves quickly in either direction. Calls are for when you expect the stock to go up, and puts are for when you expect the stock to go down.

Long Straddle

Amazon (AMZN) often has volatile price swings post earnings, and for this reason option traders apply a long straddle before earnings announcements. Below is a calendar of AMZN options expiring at the close, August 17, 2012.

AMZN qouteAMZN calendarClick to enlarge

To employ the straddle option strategy for a bullish outlook on AMZN earnings, a trader enters into two option positions, one call and one put. The trader wants to purchase 10 contract (1 contract = 100 shares) for a call and 1 contracts for a put position. The call for a $250 strike out-of-the-money option total cost is $2,050 ($2.05 per contract option x 100 shares x 10 contract). For in-the-money $250 strike put option total cost is $2,750 ($27.50 x 100 shares x 1 contract).

Say that the price of AMZN stock ends up at $260 at the close by August 17. The put option will expire worthless and the loss will be $2,750 to the trader. The call option, however, has gained considerable value. The value of 10 contracts of an in-the-money expired call option would be worth $10,000 ($10 per option x 100 shares x 10 contracts). So the total gain the trader has made, minus $2,750 loss, is $7,250.

Lets say for instance AMZN misses earnings estimates significantly, and AMZN stock trades $200 at the close on August 17. The put option would be worth $50.00, total value of $5,000 ($50 per contract option x 100 shares x 1 contract). The call options will expire worthless and the loss to the trader would be $2,050. In this case the total gain the trader has made, minus $2,050 loss, is $2,950.

Note: A trader can sell the underlying, in this case AMZN, at anytime. He or she does not have to hold an option through the expiration date.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.